Non-performing loans at the dawn of IFRS 9: regulatory and accounting treatment of asset quality

Abstract

Asset quality is a key indicator of sound banking. However, it is difficult for banking regulators and investors to assess it in the absence of a common, cross-border scheme to classify assets. Currently, no standard is applied universally to categorise loans, the most sizeable asset on banks’ balance sheets. As a corollary, definitions of non-performing loans (NPLs), despite recent steps towards greater harmonisation, continue to vary between jurisdictions. This paper offers a comprehensive analysis of NPLs and considers variations in the treatment of NPLs across countries, accounting regimes and firms. The paper relies on a multidisciplinary perspective and addresses legal, accounting, economic and strategic aspects of loan loss provisioning and NPLs. A harmonised approach to NPL recognition is particularly desirable, in view of the fact that IFRS 9, the new accounting standard on loan loss provisioning, will be mandatory from January 2018. IFRS 9 changes the relationship between NPLs and provisions, by relying on greater judgement to determine provisions. The potential for divergence makes the need for comparable indicators against which to assess asset quality all the greater.

Commercial loans are classified as follows: (1) normal; (2) special follow-up; (3) substandard; (4) high insolvency risk; (5) unrecoverable; and (6) unrecoverable based on technical criteria. Special follow-up loans are divided into: (a) under observation, include those debtors up to 90 days past due in situations that if not controlled or corrected in a timely manner, could compromise their repayment capacity; and (b) those under negotiation or with refinancing agreements, which include debtors that although unable to pay their obligations under the agreed conditions, have declared their intention of refinancing their debts no later than 60 days after becoming past due

A facility must be classified as impaired regardless of whether it is 90 days or more past due, when there is doubt as to whether the full amounts due, including interest and other payments due will be achieved in a timely manner. This is the case even if the full extent of the loss cannot be clearly determined. Such a requirement applies particularly to the range of flexible financing facilities common in the Australian financial system, including loans where repayment of principal and interest occurs only as a single payment at maturity

Office of the Superintendent of Financial Institutions considers the below listed conditions to be indicative of non-performing status: (1) a payment on a deposit with a regulated financial institution or a restructured loan is contractually 90 days in arrears; (2) a payment on any other loan (excluding credit card loans) is contractually 90 days in arrears unless the loan is fully secured, the collection of the debt is in process and the collection efforts are reasonably expected to result in repayment of the debt or in restoring it to a current status within 180 days from the date a payment has become contractually in arrears; and (3) a payment on any loan is contractually 180 days in arrears

According to the supervision rules, commercial banks classify their loans into five categories—pass, special mention, substandard, doubtful and loss. Special mention loan means the borrower has ability to repay the loan currently, but may be affected by some unfavourable factors. The last three categories of loans are referred to as NPLs

The national accounting framework provides the concept of ‘doubtful’, whose definition is similar, but non-identical to the ‘non-performing’ one as provided by the European Banking Authority (EBA). Loans are considered as doubtful when the debtor is considered as “unlikely to pay” or when 90-day past due amounts exist (for some types of exposure, the period could be longer, which explains why the definition of doubtful is similar, but not identical to the EBA one). According to the credit risk and asset quality classification, impaired loans and past due are > 90 days loans to total loans

The German legal framework does not provide specific guidelines for NPL recognition and classification/write-off. The General Banking Act of Germany does not explicitly refer to performing/non-performing loans. NPLs refer to non-performing exposures (NPEs)—as defined by the EBA Implementing Technical Standards on supervisory reporting on forbearance and non-performing exposures (EBA ITS)—excluding debt securities. According to the IMF Country Report 16/189, loan classification and provisioning are considered as an accounting issue. The supervisors do not reclassify loans or request increased provisions and rely on capital add-on. For portfolios of credit exposures with homogeneous characteristics, the exposures are classified when payments are contractually in arrears for a minimum number of days (e.g. 30, 60, 90 days)

Banks are required to classify non-performing assets (NPAs) further into the following three categories based on the period for which the asset has remained non-performing: (1) sub-standard assets; (2) doubtful assets; and (3) loss assets. A sub-standard asset would be one, which has remained NPA for a period less than or equal to 12 months. An asset would be classified as doubtful if it has remained in the sub-standard category for a period of 12 months. A loss asset is one where loss has been identified by the bank or internal or external auditors or the Reserve Bank of India inspection, but the amount has not been written off wholly. A NPA is a loan where interest and/or instalment of principal remains overdue for a period of more than 90 days in respect of a term loan. According to the IMF Country Report No. 16/76, stressed loans include NPAs and restructured advances (i.e. loans that have been subject to stress and are thus more likely to turn into NPAs)

NPLs are loans classified as substandard, doubtful and loss. Debtor has defaulted when: (a) there are arrears in principal and/or interest payments and/or other claims for 90 days although the Earning Assets (Bank fund provisions for gaining revenue, which are in the forms of credits, securities, interbank placements, acceptance claims, claims on securities purchased under resale agreements, derivative claims, equity participations and off-balance sheet items) have not fallen due in the above-mentioned categories; (b) payments on principal and/or interests and/or other claims have not been received at the time the Earning Assets fall due; and (c) other requirements aside from payments of principal and/or interest have not been met, which can cause event of default

According to Circular 272/08, the Bank of Italy adopted the following breakdown of NPLs: (1) past due/overdrawn exposures (past due by 90 days or more, with a further breakdown by days past due band); (2) unlikely to be paid exposures (with a further breakdown by days past due bands); and (3) bad loans (state of insolvency). When applicable, NPL forborne exposures are included in each of these categories. For performing exposures, the Bank of Italy has provided the following classification: performing; performing, but past due by less than 90 days (1–30 days, 30–60 days, etc.); and performing forborne (with a distinction between one concession and more than one concession). With respect to forborne exposures, for regulatory purposes the Italian banks are required to follow the criteria defined by the EBA ITS. Also, Italian banks are legally required to comply with the EBA ITS regarding the definition/classification of NPEs. The Bank of Italy does not provide regulation concerning specific provisioning rules for NPLs, also in terms of how to treat the recovery time estimation. There are no specific national guidelines or rules for NPL write-off

Loans are classified into four categories: (1) bankrupt or de facto bankrupt (“bankrupt or quasi-bankrupt”); (2) doubtful; (3) special attention (“needs attention” or “substandard”); and (4) normal. Bankrupt or de facto bankrupt loans are those extended “to debtors who are legally and formally bankrupt, i.e., in the process of liquidation, reorganization and rehabilitation, or virtually bankrupt with no prospects of resuscitation”. Doubtful loans are those extended “to debtors who have not gone bankrupt but are in financial difficulties, and thus whose lenders are unlikely to receive the principal and interest concerned on due dates”. Special attention loans are those “whose interest and/or principal payments are in arrears by 3 months or more, and restructured assets with changes in terms and conditions”, and the normal loans are “all loans to debtors who have no particular problems with their financial conditions” which are not classified as any of the first three categories. The total amount of NPLs is the sum of loans that are categorised as “bankrupt or de facto bankrupt”, “doubtful” and “special attention”

Under the asset classification rule, there are five classifications applicable to a bank loan: normal, precautionary, substandard, doubtful, and presumed loss. Loans classified as either substandard, doubtful, or presumed loss are collectively referred to as substandard or below loans (SBLs). The SBL classifications are influenced by forward-looking criteria (FLC), so a performing loan that currently generates interest income may be classified as an SBL if it is determined that the borrower’s debt-servicing ability has significantly deteriorated and has raised the risk of future default. In contrast, the primary determining factor an NPL classification is whether a loan currently generates interest payment, so a loan would not be classified as an NPL if it continues to generate interest income

There is no formal definition of NPLs under Mexican legislation. Banco de México does not provide specific rules for NPLs classification. In order to reclassify the loan as non-performing, 90 days must go by after the end of the extension period. The adjusted delinquency rate is the non-performing loan portfolio plus write-offs over the previous 12 months divided by total loan portfolio plus write-offs over the previous 12 months

There is no exact definition of “non-performing loan” under the Russian legal framework. The Bank of Russia shares an approach used in international practice, considering NPLs as loans with overdue debt over 90 days. The loans quality categories (probability of impairment of a loan) are classified on the basis of professional judgment using combination of two classification criteria (the borrower’s financial position and the debt service quality). Loans are classified (except for loans grouped in a portfolio of homogeneous loans) into one of five quality categories: (1) standard loans—no credit risk; (2) non-standard loans—moderate credit risk; (3) doubtful loans—considerable credit risk; (4) problem loans—high credit risk; and (5) loss loans—no possibility of loan repayment due to the borrower’s inability or refusal to meet loan commitments, which stipulates complete (100%) impairment of the loan. Loans classified as non-standard loans and loss loans are impaired

Credit risk comprises the following loan classification: (1) impaired loans; (2) defaulted loans; (3) past due loans (less than 90 days, 90–100 days, 180–360 days, over 360 days); and (4) allowances (specific allowances and general allowances). While past due loan simply means a loan which has not been paid on time and is now overdue by certain days (which after 90 days falls in the definition of default). Non-performing loans are considered to be loans that are more than 90 days past due

According to the South African Reserve Bank, the loan should be classified as non-performing in line with the bank’s credit and write-off policy. Loans which are in arrears (but not in default) and which are restructured should not be classified as performing until such time as the obligor’s ability to meet the requirements of the revised terms and conditions has been established. Credit risk exposures are classified as either “standard”, “special mention”, “substandard”, “doubtful” or “loss” by South African banks and reported on a quarterly basis

The Regulation on Procedures and Principles for Determination of Qualifications of Loans and other Receivables by Banks and Provisions to be Set Aside (Article 5) requires banks to categorise loans and receivables under five groups. Loans categorised in “Group 1—Standard” and “Group 2—Special mention” are performing loans. Loans classified in the remaining 3 categories are considered non-performing loans. Following are the criteria for those non-performing categories. Group 3—Limited recovery: past due between 91 and 180 days or limited recovery expectation due to financing and liquidity problems of the debtor. Group 4—Suspicious recovery (doubtful): past due between 181 and 365 days or substantial deterioration in the creditworthiness of debtor, but not considered loss because of the partial recovery expectation. Group 5—Loss: past due for over 365 days or no recovery expectation due to the significant deterioration in the creditworthiness of the debtor

NPLs are not formally defined at UK level for supervisory purposes. The EBA definition is used for regulatory reporting. The definition for forbearance should be taken from either: (1) the EBA consultation paper on Implementing Technical Standards on Supervisory Standards and (2) the definition of forbearance as detailed in the guidance published by FSA (now FCA) in 2011

A loan is classified as a non-performing exposure where the loan is 90 days past due or if there is a risk of unlikely repayment without realisation of collateral. The definition applies regardless of the classification of a loan or debt security as impaired or defaulted, but a loan or a debt security that has been classified as impaired in the financial statements or that has been classified as defaulted in capital adequacy shall always be classified as a non-performing exposure according to EBA’s definition. This definition applies in parallel to the definitions reported in this table for those jurisdictions that are members of the European Union (France, Germany and Italy)

Appendix 2

For all GSIBs, 90 days past due is not a sufficient condition for a loan to be considered to be an NPL. Qualifications on the 90 days past due criterion for NPLs are given below. This information is primarily obtained from the 2014/2015 Financial Statements of the GSIBs. Column 1 gives the overriding criteria of NPL/impairment status which can include, but may be independent of the 90 days past due criterion. The purpose of Column 2 is to ascertain if credit card loans and non-secured loans are treated differently from the general criteria used. Column 3 lists any exceptions to the treatment of Home Equity Loans. Column 4 gives the cases when a non-accrual status is used58 with the latter needing specific material evidence for problems of non-payment. Here we note that ‘non-accrual’ is widely used in the USA, but does not exist as a concept under IFRS; hence, US banks will have a yes in Column (4) and typically non-US banks do not. ‘No Disclosure’ (ND) is inserted when there is no specific information given in the Financial Statements of GSIBs and ‘Not Applicable’ (NA) where a practice (non-accrual of interest) is not permitted by the accounting framework used by the bank.

Loans have non-accrual status if general criteria apply with Col 5 exemptions

120 days past due for real estate 1–4 family and first and junior lien mortgages which are not mortgage loans and some consumer loans

aFor example, the bank uses terms such as ‘substandard’ or ‘doubtful’ for deteriorated loans or ‘write-off’ where legal measures have been exhausted, and/or has other set criteria based on number of days past due